Moody’s No Longer Grading CLO “Combo” Notes on a Curve

CLO managers could find it harder to attract investors in the riskiest slices of their deals under revised rating criteria announced by Moody’s Investors Service this month.

The rating agency has changed the way it assesses the risk of combo notes, a hybrid debt and equity instrument, to account for what happens to them when a deal is refinanced. This could result in downgrades on existing combo notes issued by 38 collateralized loan obligations. It could also complicate the way future combo notes are structured.

CLOs issue combo notes to attract investors who are unable to invest in the most subordinate securities that they issue, known as the equity. The combine the equity, which pays no interest and is unrated, with a more senior tranche, creating new securities with characteristics of both classes. The deals are largely driven by investor queries into how they can buy up equity stakes in CLO deals when they are constrained by regulatory or internal limits on unrated notes.

There are some 135 outstanding CLOs rated by Moody’s, including deals from Carlyle Group and CVC Credit Partners.

Fitch Ratings and Standard & Poor’s also rate combo notes, and neither has announced plans to revise their methodologies. (A buy-side source told Asset Securitization Report that ratings from Fitch or S&P would likely “suffice” in place of one from Moody’s for any CLO investor requiring a rated instrument).

Combo notes are structured to meet the requirements of investors themselves, in order to meet their requirements for a security that has a credit rating or generates sufficient return.

When CLOs are refinanced to take advantage of lower prevailing interest rates, all of the notes save the equity are paid off and new notes paying lower interest rates are issued to existing investors. This deprives combo noteholders of the rated component, while sharply reducing the remaining principal.

Under its revised criteria, Moody’s will rate combo notes so long as they continue pay the full promised principal and interest to maturity. But the agency will no longer apply ratings using a “rated balance” – it’s former method that effectively applied its rating to the principal only.

Moody’s original methodology was structured more than a decade ago as combo notes became features of CLOs and collateralized debt obligations. Only in recent years has the refinancing of these notes because a staple in the life of a CLO portfolio.

In one example, an April 2015 refinancing of CVC’s Apidos CLO IX transaction issued in June 2012 resulted in the redemption of Class B notes from an $8.4 million combo note principal balance, leaving $1.08 million balance of equity notes remaining in the combo notes strip. This prompted Moody’s to cut its rating on the combo notes tranche from ‘Aa2’ to ‘Ba2’.

It was one of several CLO combo note tranches Moody’s downgraded in 2015 and 2016, prompting its decision to revise its methods.

The question now is whether the move will hinder the investors looking to get into CLOs through combo notes – or could induce existing CLO combo note holders to divest their holdings and depress market prices.

After Moody’s proposed its changes last spring, investors, managers and industry officials submitted written comments that largely painted the revision as unnecessary.

In June newsletter, the Loan Syndications and Trading Association said that existing methodology was well understood, and accepted, by investors who were aware of the refinancing risk. In addition, the trade group said, the complete absence of ratings contemplated by Moody’s could “stymie” the CLO market by depriving it a resource for “optimizing CLO products to investor demands.”

In a comment letter published the same month, Gretchen Bergstresser, a senior portfolio manager of CVC Credit Partners, urged Moody’s to stand pat lest it drive some institutional investors out of the marketplace. “Some of these investors prefer to invest in a rated amalgamation of CLO securities (rather than directly investing in multiple tranches) in order to permit investment in non-rated subordinated securities” they otherwise couldn’t due to regulatory or internal limits, she wrote.

Indeed, investor clients of New York law firm Seward & Kissell would find direct purchases of unrated CLO equity or lower-rated CLO securities tranches “impossible or extremely problematic” without a repackaging through rated combo notes, wrote Greg Cioffi, a partner at Seward & Kissel.

With Moody’s maintaining ratings for combo notes that will honor “contractually promised” payments of P&I, the investor-side source was optimistic that “there are ways that repackagings of CLO securities can be rated by Moody’s” going forward.

The downgrade review of 38 outstanding CLO combination notes outstanding will continue through the beginning of 2017, according to Moody’s. The deals impacted include multiple portfolios issued by CVC, Oaktree Capital Management, Voya Investment Management and Symphony Asset Management, with ratings on their combo note tranches ranging from ‘A3’ to ‘Baa3’.

Moody’s limited its scope to those deals it considers most likely to refinance. The agency excluded deals prior to 2008, notes with principal protection on securities or that prohibit refinancing, or those that may be close to exiting their reinvestment periods.

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